Option Investor
Market Wrap

Zigging and Zagging

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How many of us feel like we're zigging while the market zags and then when we figure out the direction of the zag and enter a trade to go with it, the market then zigs. Nobody said it would be easy but it'll be nice when we can trade a market that's not quite so manic. Tight consolidations followed by spike moves seems to be the modus operandi for this market and the tough part about trading this kind of market is that the fast moves tend to be over by the time you see the trend and try to trade with it. It will get better (easier) but this is the market we have and it's the one we need to learn how to trade. Traders are united in their chorus of complaints about how difficult it is to trade this market so know that you're not alone.

If you're not a scalper and day trader then you have an even more difficult time as the market tends to reverse before profit targets are hit (even scaled back profit targets). Then stops are hit for small losses and the market does the same thing in reverse. Rinse and repeat. If you're a trend trader or swing trader I know you've been highly frustrated by this market. If you're a scalper/day-trader and you're able to catch the turns, you're having a very good time in the market. If you're a swing trader and can't stomach day trading then be patient and preserve your capital as things will get significantly better soon and you want to have capital in your account to take advantage of it. We should be getting very close to figuring out whether or not we have a trend change upon us or a little higher before a market top. I'm thinking a little higher first.

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This morning we got a couple of economic reports that set the tone for the morning. Initial jobless claims fell 6,000 to 308,000 (315,000 expected). The four-week average of new claims fell by 7,250 to 309,250, the lowest since Feb. 26. Continuing jobless claims fell by 8,000 to 2.57M.

The July retail figures were released and while there was nothing exciting in the numbers, it at least showed continued growth. Sales rose 1.8% in July, above June's 1.7% gain. The strength in sales was helped by auto sales which experienced the strongest growth in nearly four years due in large part due to the auto companies' "employee discount pricing" programs. Excluding the 6.7% rise in auto sales, retail sales increased a more modest 0.3% in July (and it was flat if you take gas sales out of the equation). Economists had expected sales to rise 1.9%, with ex-auto sales up 0.6% so the total was a little less than expected but still rising. Retail sales are now up 10.3% in the past year, the fastest gain in 11 years. Long live the consumer.

Business inventory numbers were released later in the day and while the market usually ignores this number, which was flat in June versus an expected 0.1% rise, more attention is being paid at the moment due to its potential impact on GDP growth. This was the first flat month after nine months of growth in inventories. In the meantime sales increased 0.7%. The inventory-to-sales ratio therefore fell to a record low of 1.29 in June. The typical business had 39.3 days of sales on hand.

With inventories tightening and sales strong, economists expect production at U.S. facilities to ramp up in coming months to meet demand. Economists also believe imports will likely increase. (I won't get into how I feel about economists' forecasts, but let's just say weathermen have a better success ratio). In the first estimate of Q2 GDP, slower growth in inventory building was said to have subtracted 2.4% from growth. Economists now expect U.S. GDP to grow at least 4% in the current quarter, up from 3.4% in the second quarter. The report, coupled with tomorrow's June trade deficit report, could provide the basis for any revisions to Q2 GDP. Q3 real GDP estimates appear headed for an increase of 5% or more. These reports and expected GDP growth are what is credited with today's rally. It is truly a fickle market. Oil matters one day and then the next day oil at a dollar higher doesn't matter but growth does. Tomorrow growth won't matter but something else will. This is why I trade the charts.

Speaking of the charts, let's have a look see.

DOW chart, Daily

The 10600 level continues to act as the center point of an oscillating market. For the past month the DOW has traded in essentially a 100 point range. I've mentioned it before and I'll mention it again--every single time in the history of the stock market since 1928 (when intraday data has been collected) when it has traded in a tight range like this, it has always resolved higher. Sometimes the rally is preceded by a 1-2 day sell off (could be what we just had at the end of last week) but that is then followed by a rally out of the consolidation. It could fail to happen this time but I don't like trading against those kinds of odds. I expect a rally out of this consolidation. The upper trend line on this chart (previously broken uptrend line that has been acting as resistance) is up near 10850.

SPX chart, Daily

The consolidation on SPX is not nearly as apparent as on the DOW. The strong Fib magnet in the 1253-1257 zone has not been hit yet. The trend line intersection is in the same zone. If the DOW rallies out of its congestion, this one surely will as well.

SPX chart, 120-min

Zooming in a little closer to the SPX, there is an internal wave count Fib projection that points to 1253.71 (hmm, amazingly in that same 1253-1257 zone on the daily chart). But bears beware. I've got the move up from July 7th labeled as an A-B-C move (for Elliott Wave followers it's a 3-wave move for the 5th wave in an ending diagonal). If the 1254 level is exceeded, and especially if 1257 is exceeded, the next Fib target is 1272.73 (1278 is a strong Gann number) where wave-C = wave-A. I have no idea if the market will rally up to this level but it's entirely possible. We're in irrational times for this bull cycle and picking a top continues to be dangerously difficult.

Nasdaq chart, Daily

After banging its head on the trend line across the highs from January 2004, the COMP has pulled back sharply. Whether or not it can break above that line and head for its Fib target at 2248 remains to be seen. It will depend on the others indices. Watch the uptrend line of its steeper up-channel which is just under 2150.

RUT chart, Weekly

The weekly chart of the RUT shows a bearish picture. So again, depending on how the other indices do will help determine where this one is headed. It might even be leading the pack and showing us a high is already in (or will not make a new high and give us an intermarket bearish divergence). The RUT hit both its Fib target and the upper trend line at the same place (near 690) and the weekly chart appears ready to roll over. This one looks bearish but might be able to give us one more minor new high before it's done.

SOX index, weekly chart

The weekly chart of the SOX, like the RUT, looks bearish. It ran into both its Fib target and the top of its bear flag pattern near 481. However, if the broader market rallies some more, watch the upper Fib target near 520 as an upside target for the rally.

BKX banking index, daily chart

Banks are downright bearish and based on just their pattern I'd be recommending long term bearish plays for the other indices. But this one may be giving us a heads up as to what's coming but the others, like the DOW and SPX, just don't know it yet. I would be short the banking sector based on this chart, especially after the daily stochastics recycles back up to overbought at a lower high.

XBD securities broker dealer index, weekly chart

It's been a month since we've looked at the securities index. While the index has hit its Fib target just above 172, it may head a little higher still. But this index looks like a short play waiting to happen. And as the brokers and banks go, so goes the market. These two sectors give me the heebie jeebies about being long the market (except for scalping plays).

The banks are normally hurt by a rising Fed yield rate versus the bond yields which have refused to budge much (see Jeff's earlier Wraps where he does a good job explaining this) and this could help explain the drubbing the banks have taken recently. For shorter term action the equity market many times responds favorably to a drop in yields with the thought that companies will be able to continue borrowing more cheaply. This looks to have had some effect today. There was an auction of $13B in the 10-year Notes which gave investors a coupon of 4.35% and Notes enjoyed a surprising indirect bidder participation of 46.9%, which provides reassurance that there is still strong foreign demand for U.S. Treasuries. Also helping international companies, the U.S. dollar fell to a 10-week low against the euro (1.2436) and a 6-week low against the yen (109.88). This was attributed to solid euro-zone growth figures, a disappointing headline read on July retail sales and strong follow-through buying in Japanese equities, which lifted the Nikkei 225 ( 1.4%) to another new 52-week high.

Last week the market was worried about growth that was too fast and there was a lot of worry about how the Fed would react. We got the usual gyrations around the FOMC but the market is essentially where it was pre-FOMC. Last week, once the market got a whiff of too much growth, there were additional fears of how quickly the Fed would raise interest rates which caused investors to hit the sell button. Those who were once so sure the Fed was done raising rates suddenly became worried that the Fed is far from done. Now many are worried that the Fed is going to continue for too long as they have in the past which will cause the economy to slow down too fast again (thus causing a recession). The Fed is worried about an overheated economy while the market is worried about one that's going to slow down too fast.

The Fed is actually running scared right now. They've been dropping little bomb shells on the market recently indicating as much. They're now worried about the housing bubble they helped create and would like to have the air let out slowly from the bubble rather than see it get popped. But the bond market hasn't been cooperating. The Fed has been asking the bond market for help so that the Fed can stop raising short term rates. If the bond market would start slowly selling bonds and let the rates rise slowly, the Fed envisions a cooling off in the housing market while they can avoid causing a 1990's style market meltdown, especially in the housing market. They know the housing market is now the most vulnerable and if rates rise too rapidly it could cause a shock that will be felt throughout the economy.

What the Fed doesn't realize, or has refused to acknowledge, is that it can not control market forces. The demand for our Treasuries is market driven and has to do with global demand and our country's insatiable appetite for credit, whether it's the government, corporate or consumer. Credit has been cheap and we're all drunk on it. So the Fed has been forced to raise rates faster than desired and the bond market keeps thumbing their collective noses at them. Fed officials see similarities between the attitudes of bond investors today and of stock investors in the late 1990s. The big difference for our economy, and the global economy, is that a collapse in the bond market would be far more damaging than a collapse in the equity market. And this is why the Fed is starting to run scared. My guess is Greenspan wouldn't mind stepping down now rather than later.

So the Fed has now taken to issuing more direct and blunt statements than the market is used to. And that in turn is now scaring the market. The bond market has finally begun to react "appropriately" and has been selling off. This has caused the equity market to also sell off but the Fed probably looks at it and shrugs its shoulders with a "yea, whatever". They care much more about the bond market than equities. While in February Greenspan was describing the bond market's refusal to follow his lead a "conundrum" he has recently been declaring the disconnect as meaning bond owners are too complacent about long term low inflation and economic stability. He now says "Long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress." Substitute the words "a bubble" for "financial excess" and "crash" for "economic stress" and you can see why the market finally reacted last week. His statement was very similar to the one he made in 1999--substitute the word bond for equity in the following 1999 quote, "An unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable ... (which) could create problems for our economy when the inevitable adjustment occurs."

I still owe you an explanation about how China fits into our equation which I'll try to lay out over the next several weeks. Briefly, we've heard about the demands China has placed on global resources, including oil but really on most commodities. We also know that they are heavy purchasers of our Treasuries. The money we spend on Chinese goods comes back to our country via purchases of our debt. That's an unhealthy exchange but that's what happens when we give up our manufacturing base and become a service-based economy instead. It's also a result of our insatiable appetites and consume far more than we should. So what happens when we stop spending? If the consumer and corporations are hit with rising interest rates and start keeping their wallets closed, our economy will start to slow down. Jobs will be lost, the housing market will take a hit, and the slow down in spending will also hit countries like China (and others dependent on the American consumer). Without the cash coming into China for their products, they will slow down their buying of our Treasuries. In fact they will likely cut their purchases of our Treasuries even faster because they'll need to internally fund their spending that is currently being funded by American business. China itself appears to be slowing down as well. The IEA lowered China's 2005 oil demand forecast to 4.9% from earlier (April) estimates of 7.9% growth and well below last year's 14% surge in China oil demand.

This could all unravel quickly and have a very negative effect on our markets in short order. It's not unreasonable to think that we could see another Asian meltdown similar to the one in 1997 from the Thai Bhat debacle. It's not unreasonable to think that we could see a drastic chain of events in this regard by this coming fall. And this is why we could see a global impact to such a scenario and the global result could be a global recession. The general consensus is that this could not happen and then we go back to Greenspan's comment about the complacency he sees in the market's expectations for long term stability. A global recession would affect the price of everything including commodities which includes the price of oil. Oil is in a major bull market but it too will likely see a large price drop during this "correction". The lack of demand for oil will inevitably cause the price to drop. A significant drop in the price of oil (and by that I mean back down into the $40 price range) might then create some geopolitical instability in countries dependent on oil income, namely some of the OPEC producers like Venezuela and others like Russia.

Therefore the immediate future holds the potential to be very volatile as the market tries to cope with what this all means. It may be part of the choppy volatility we're currently seeing--there are huge disagreements between the major players right now and they argue with massive amounts of money. Rising rates will likely cause some significant market "adjustments" and a collapse of the housing bubble (I don't believe the bubble will have the air let out slowly), a slow down in the global economy and the potential geopolitical instability with a drop in oil's price are all negatives when it comes to the bond and equity markets. Last week's selling in both was an indication the market is getting a whiff of these dangers. It is a time for us to be very cautious, probably even more so than we needed to be in the late 1990's and 2000 as the market was peaking at that time. If the bond market will be the primary driver this time, the equity market will likely react universally negative. In other words it won't be just the tech stocks this time.

Protecting your capital could very well be your primary objective very soon. We try to protect retirement accounts, especially for our older family members such as our parents' accounts, but as traders we just want a trending market. If we start back down in a long decline, we could see some very lucrative trading opportunities. If you're not comfortable trading the short side of the market, whether it's shorting stocks or futures, buying puts, selling bear call spreads or any number of ways of participating in a bear market, you could have a tough trading environment soon. Learn to trade both sides of this market and you will soon not care which way it goes. Just as long as it goes.

Crude spiked to a new high today, getting above $66, but didn't slow the bulls down today. But even oil looks very close to a high.

Oil chart, August contract, Weekly

This weekly chart of oil shows how dramatic the climb has been. The up-channel for price action since the end of 2004 has the top of the channel near $69. Internal Fib projections for the current leg up coincide around $69.40 so watch for a rally to peak out somewhere under $70. I am expecting a much deeper retracement after that.

Oil Index chart, Daily

The oil index is looking like the housing market did just before its collapse. I expect a similar outcome for these stocks. Many are bullish these stocks but I think they'll take a hit along with the rest of the market. As oil is nearing $70 this index should start to give a heads up about oil's peak. If this index doesn't start turning back down soon then it would be a signal that oil may keep rallying so watch these two together. If you're long this sector I would take profits soon (raise stops up just under the steep uptrend line) and watch to see if the 50-dma holds on a pullback. I think it will head back down to the bottom of the up-channel.

Transportation Index chart, TRAN, Daily

The TRAN may be signaling a high in the market but I'm thinking it could press a little higher, especially if the broader market does. The upper Fib target just under 3900 remains a possibility. But if this turns back down below the recent lows, that would likely be a good heads up for the broader market.

U.S. Home Construction Index chart, DJUSHB, Daily

What goes up must come down. Sometimes it takes a while for it to come back down but it will. The housing index is saying the housing market has seen its highs. I expect the high in this market is in and the consequences for the broader market will be negative. It's just a matter of time now. Goldman Sachs Chief economist Bill Dudley had said earlier this week that the FOMC will want to tighten credit to slow the economy and keep inflation at bay. "The risks are increasing that monetary policy may need to be made tight," Dudley wrote in a note to clients. "It should only take a relatively modest rise in long-term rates to take the steam out of the housing sector and for this to lead to a significant slowing in consumer spending." Me thinks the housing market already senses this.

U.S. Dollar chart, Daily

The U.S. dollar is clearly correcting the rally from earlier this year. It's now approaching its 200-dma and is closing its gap from the end of May so I expect to see the dollar get a bounce. The form of the bounce will give some clues as to what's next after that. If we get an overlapping corrective sideways/up correction then I'll be looking for lower lows in the dollar. But if we start getting a sharp rally back up then it will be possible the dollar will be headed to new highs.

Gold chart, August contract, Daily

Looks like a break out in gold. After consolidating all year it looks like gold is finally breaking out. But watch the dollar here since these two are trading inversely. If the dollar gets a little bounce watch to see if gold pulls back to the broken downtrend line near 440. If that line holds, it should be a good opportunity to get long the yellow metal.

Sector action today was all green except the retail index which was negative by only 0.20%. The green sectors were led by the gold and silver index, biotech, technology, oil and healthcare. The laggards today were the oil service, telecom, transports and banks/brokers. There were the usual upgrades, downgrades and nogrades. Goldman Sachs lowered their rating on Intel (INTC 26.82 -0.06), and Freescale Semi (FSL) and JP Morgan downgraded Novellus Systems (NVLS) while a UBS upgrade on Alcoa (AA) and better than expected Q2 earnings from Target (TGT 55.64 0.10) helped the blue chips. There was continued weakness in Cisco Systems (CSCO 18.06 -0.19) and consolidation in Dell Inc. (DELL 39.58 -0.15) ahead of its Q2 report.

Speaking of its earnings report, after the bell Dell reported a profit of $1.02B, or 41 cents a share, compared to $799 million, or 31 cents a share in the year-ago quarter. Revenue rose to $13.43 billion from $11.7 billion. Sounds pretty good to me but as usual it was not good enough--Dell sold off on the news (the number fell short of analysts' $13.7B estimate). Excluding one-time items, Dell earned 38 cents a share, to meet the 38 cents a share estimate of analysts surveyed by Thomson First Call.


Health Care benefited from solid follow-through in HMOs and a 2.0% surge in Hospira (HSP 38.54 0.74), which beat analysts' Q2 expectations and issued upside FY05 guidance. Consumer Discretionary benefited from a rebound in Walt Disney (DIS 25.88 0.41), amid reports that News Corp (NWS 18.03 0.59), which also beat expectations, has budgeted $2.0B for potential acquisitions. Matching Energy's 1.1% performance was the Industrials sector, as investors picked up beaten down blue chips, especially heavy exporters like General Electric (GE 34.51 0.63) and United Technologies (UTX 51.63 1.65) which benefited from a weak dollar.

Tomorrow's economic reports include the following:

With so many traders absent during the month of August, it has tended to be one of the worst performing months of the year. However, looking at the past 5 years you can see that August has actually been a pretty good month. But the times August was a good month usually followed a July that tended to be down or even. We had a very solid July this year so I'm not so sure we can take away much from these patterns. The "typical" market action this year has been opposite what's usually expected to I don't follow the Stock Traders Almanac since it's been more inaccurate this year than accurate. The market appears to be in a topping process and as such is a very difficult market to trade. A distribution pattern, which is what it looks like to me, is typically full of volatile, whippy, trader-bruising sessions. Sounds familiar, no? It's a battle between the bears who are convinced this market is way overbought and propped up on fluffy stuff and the bulls who are convinced the economic growth will continue and that since this is 2005 (a year ending in '05') we'll have an up year.

I throw myself into the bear camp which says the market is close to peaking, if it hasn't already peaked (and some indices may have already peaked). But I also recognize that the peak in the current cyclical bull market (that we've been in since October 2002) will likely see an excessive amount of bullishness, greater than that which we saw in 1999-2000. This makes identifying a top more difficult than usual, and in fact I would say much more difficult. Therefore I'm watching the charts, not sentiment or VIX or put/call ratios, or short interest, or any of those typical measurements to give some clues as to where a top might be. In fact because I expect a top to be so difficult to find I'm perfectly happy to find it in my rear view mirror. I consider picking a top far too dangerous this time around since it could go a lot higher and take a lot longer than I would normally expect. I'm in prove-it-to-me mode and in the meantime I'm taking the opportunity to get long the market when I see some upside potential.

But the surprises in this market will very soon be to the downside. Therefore, unless you're nimble and can watch the market every day and preferably during the day, I consider the upside too risky. You need to be ready to jump out quickly. Take trades in both directions and be happy with base hits right now. It's too early to be thinking home runs here. A base hit every day will get you a lot further ahead. It's a time for very cautious trading so good luck and be careful out there.
 

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